4 top things you need to know about tax saving funds
Investors can save up to Rs 46,350 in taxes per year by investing up to Rs 1.5 Lakhs in eligible schemes under Section 80C of the Income Tax Act 1961. There are broadly two types of tax savings schemes – risk free or low risk schemes and market linked schemes. The risk free or low risk schemes are Public Provident Fund (PPF), National Savings Certificates (NSC), 5 year tax saving Fixed Deposits (offered by banks and post office), traditional life insurance plans (e.g. endowment plans, money back plans etc.), Senior Citizens Savings Schemes etc. In these schemes capital safety is assured. In some schemes like NS and FDs, returns in terms of assured interest are guaranteed, while in others the interest rates can change from time to time during the investment tenure.
The market linked schemes under Section 80C are tax saving mutual funds or ELSS funds and Unit Linked Insurance Plans offered by life insurance companies. Tax saving mutual funds and ULIPs invest in capital market securities and therefore, they are subject to market risks. If you want assurance of capital safety then market linked schemes are not for you and you should invest in Government small savings schemes (PPF, NSC etc.) or tax saving FDs.
However, if you are willing to take some risks and prepared to remain invested even beyond the lock-in period of market linked schemes, then tax saving mutual funds could be one of the best tax saving investment choices.
Here are the 4 top things that you must know about tax saving mutual funds.
- Potential of giving superior returns
- Inflation beating returns
- Favorable tax treatment
- Superior liquidity due to least lock-in period
Potential of superior returns
Historical data shows that, equity is the best performing asset class in the long term. In the last 20 years, the S&P BSE Sensex gave over 11% compounded annual returns, while bank FDs gave average annualized returns of not more than 7% during the same period. Investors who focus simply on tax savings and ignore the growth potential or the tax implications on the maturity amount result in getting sub-optimal returns.
Tax saving mutual funds on the other hand offer both, 80C tax savings and wealth creation potential over a sufficiently long investment horizon as it invest in equities. For example – ELSS as a category has given over 18% annualized returns in the last 5 years (Source: Valueresearchonline.com as on 23/2/18).
Inflation beating returns
We see people complaining about rising prices, but how many of us factor in inflation when making tax saving investment decisions? In the chart below, we can see the CPI inflation rate from 2013 to 2017.
Source: World Bank
You can see in the above chart that in some years, risk free returns (interest rates) like PPF, NSC and tax saving FDs either struggled to beat inflation or gave negligible inflation adjusted returns in the last 5 years. The average inflation rate for the period from 2013 to 2017 was 6.2%. However, if you compare the post-tax returns of tax saving mutual funds with the fixed interest bearing tax saving investments, tax saving mutual funds have beaten them with wide margin - ELSS as a category has given over 18% annualized returns in the last 5 years (Source: Valueresearchonline.com as on 23/2/18).
Therefore, investors should reconsider investing in risk free investments in relation to inflation. Risk Free investments might be free from market risks, but they are not entirely risk free in the sense that, they are not free from inflation risk. If post tax risk free returns are lower than inflation, then by investing in risk free investments, the investors are destroying wealth instead of creating wealth. As we have seen, Equity Linked Savings Schemes on the other hand have beaten the inflation by a wide margin and thus created wealth for investors.
Favorable tax treatment
Tax saving mutual funds or ELSS schemes are one of the most tax friendly investment options u/s 80C.
To fully evaluate the impact of taxes on the tax saving investment and on its returns, one must understand the tax treatment at three different stages of investment – 1) At the time of investment 2) During the investment tenure and 3) On maturity of the investment.
At the time of investment, if you are in 30% tax bracket you can save upto Rs 46,350 in taxes including 4% cess by investing the maximum limit of Section 80C investment, i.e. Rs 150,000 in tax saving mutual funds.
During the investment tenure, the dividends paid by tax saver mutual funds in the hands of the investors is tax free but the scheme has to pay 10% dividend distribution tax (DDT).
On maturity of investments, though long term capital gains (LTCG) tax has been introduced in this year’s budget, the taxability of ELSS is still more attractive than some of the other 80C investment options.
Budget 2018 introduced long term (holding period of more than a year) capital gains tax @10% on equity and equity oriented funds including tax saving mutual funds. However, the above tax is payable only if you have more than Rs 1 Lakh of profit (long term) in a financial year. This is effective from April 01, 2018.
However, there is no reason to let LTCG affect the investment in tax saving mutual funds, because even after taking LTCG into consideration post tax returns could be much higher for tax saving mutual funds compared to other Section 80C instruments over a longer period. Further, the LTCG will be applicable on the capital gain amount of more than a lakh of rupees in a financial year, which could further reduce the tax burden.
Liquidity
The other important investment consideration for tax saving mutual funds is liquidity. When you make an investment, you should make sure that you are comfortable with the liquidity of the investment that you are making. Even in terms of liquidity tax saving mutual funds score over other tax saving investments as it has the shortest lock-in period of 3 years. After 3 years, you can withdraw your money as per your own requirements or remain invested if you are looking for long term capital appreciation.
As we have seen tax saving mutual funds or ELSS schemes as they are popularly known, offer superior wealth creation potential, inflation beating returns, liquidity and tax benefits compared to other 80C investment choices. You must consult your financial advisor if tax saving mutual funds is suitable for your tax planning investments considering your risk profile.
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